Negative interest rates: Keynes revisited

Negative interest rate policies have started to unnerve investors, even though Sweden, Denmark, the eurozone and Switzerland have all had negative policy rates for over a year.

Negative interest rates: Keynes revisited


This year, amid global growth jitters, investors have started to worry about whether negative deposit rates undermine the profitability of the banking sector. Japanese banking stocks have underperformed global peers by 17% since the Bank of Japan cut the deposit rate to -10 basis points on 29 January. Even more disconcerting were sharp spikes in bank funding markets, which led some commentators to question whether this could threaten their solvency. While these spikes were short-lived, many investors are wondering if cuts deeper into negative territory would see them return.

We believe that negative policy rates are not as bad for commercial banks as most people think, and that markets have overreacted. Foremost, negative rates on deposits with the Swedish, Danish, Japanese and eurozone central banks apply only to new reserves. So it is far more important to focus on the average interest rate applied to the whole stock of reserves.

In Switzerland and the eurozone, the mandatory reserves that regulators require commercial banks to hold with the central bank are not subject to negative rates. In Sweden and Denmark, a more complex system of refinancing provisions effectively negates the negative rate on mandatory reserves too.

Of course, additional asset purchase programmes by the ECB and the BoJ are likely to raise the excess amount of money banks hold on reserve above the minimum requirement threshold, and this will push up that average rate of interest. However, the positive contribution to bank earnings generated by capital gains on holdings of government bonds will provide an offsetting force. Capital Economics also calculates that the annual cost of negative deposit rates to the Swiss banking sector is equivalent to 0.04% of bank assets, and just 0.01% in the eurozone, Sweden and Denmark. Given that European net interest income is circa 1-1.5% of bank assets, the cost is not that great.

Central bank deposit rates: Negative rates are nothing new


Fundamentally, banks do not earn their profits from the money they hold on deposit – they make their money from borrowing short and lending long. In this regard, negative deposit rates are a more attractive prospect than extending QE to corporate bonds and asset-backed securities; smashing down yields here makes it even more difficult for banks to eke out a net interest margin.

So will negative interest rates come up with the goods? We are, of course, in uncharted waters. Although not explicit, most readers of John Maynard Keynes’ General Theory infer the premise, ‘[given] that nominal interest rates cannot be negative’. Nobody has really challenged that theory for 80 years! The experience so far suggests that changes to modestly negative rates are passed through to money market rates. Moreover, there is anecdotal evidence that banks are seeking to avoid negative rates in their sovereign bond holdings by lending to riskier counterparties.

Yet the evidence is mixed when it comes to lending rates into the real economy. Banks have been reluctant to pass on negative deposit rates to retail depositors for fear of substantial deposit withdrawals. It is much easier for a retail depositor to store their relatively small sums of cash in a small cupboard under the stairs, than for corporate depositors, who would need to rent specialist vault space! This reluctance may have limited the extent to which banks were willing to convert lower policy rates into lower mortgage rates, for example, eager as they were to avoid further squeezing retail net interest margins. In particular, Swiss banks have actually raised the lending rate on mortgages since policy rates turned negative, while mortgage rates in Sweden and Denmark have remained more or less unchanged.